The Galerija Centrs shopping arcade in downtown Riga is a fitting symbol of Latvia's transformation from a former Soviet republic to the fastest growing state in the European Union.

The once dowdy department store - opened in 1938 on the eve of the Soviet occupation - is now a western-style mall, with a lofty glass arcade, escalators, international brands and even a spa. Eight million shoppers - more than three times the country's population - visited last year.

The smart districts of the old Hanseatic port of Riga are also being transformed. Art Nouveau mansion blocks have been renovated, sold and now stand empty while their speculative buyers wait for prices to rise further.

EU accession in 2004 has driven growth in all three Baltic states, with structural funds fuelling the building boom in the capitals.

Migration westwards has also pushed up domestic wages and, when money is brought back, added to house price inflation.

"For decades we never had these possibilities," says Irena Krumane, state secretary at the Latvian finance ministry. "Young people are faced with aggressive media advertising pressure and they want to have everything today." The speed of this growth - particularly in Latvia - as well as its structure are also worrying international rating agencies. Standard & Poors put Estonia on negative outlook this week after doing the same to Lithuania in May and downgrading Latvia to BBB+ with a negative outlook.

Growth has been driven by domestic demand, with rising wages and soaring lending sucking in imports and pushing up inflation and house prices.

Wage growth, at about 20 per cent a year, is well above productivity increases. This is eroding industry's competitiveness at a time when imports are already growing much faster than exports.

The overheated figures have dashed the Baltic states' hopes of entering the eurozone early. Lithuania's move to adopt the euro was rebuffed earlier this year.

Inflation is now well above the limit in each country and all have dropped their ambitious entry dates and have no official target. Most analysts regard entry as unlikely before 2012.

Nevertheless, the danger facing all three states comes not so much from a collapse of foreign confidence - there is not much speculation in Baltic currencies and the banking sectors and public finances remain solid - as from the impact of any sudden change in consumer behaviour as expectations of continued future growth are dashed. This could lead to a collapse in house prices and a steep economic slowdown.

Such a "hard landing" could stop the three EU newcomers in their tracks as they struggle to catch up with western Europe. Even Estonia, the richest, is still only two-thirds of the EU average gross domestic product (GDP) per capita.

A rapid slowdown could also create a lot of red ink on the balance sheets of Scandinavian banks whose subsidiaries have done so much to stoke the Baltic boom. "The banks are absolutely responsible for the situation here," says Ms Krumane, who complains that they are focusing on lending to consumers rather than export companies.

Banks have begun imposing stricter credit policies, lending growth is slowing down (though it is still rising at 40 per cent a year) and customers are starting to save more.

"We're trying to communicate to the market the need to be cautious - don't run if you don't need to," says Audrius Ziugzda, chief executive of SEB in Vilnius.

Growth in house prices, domestic demand and GDP is slowing but wages, inflation and current account deficits are responding more slowly.

"It is looking increasingly likely that there will be a hard landing," says Kenneth Orchard of Moody's, the most sanguine of the rating agencies. "Even if growth just falls sharply, it will feel like a recession."

The central banks have few tools at their disposal to bring the economies down gently because their currencies are pegged to the euro or managed by currency boards. Fiscal policy must, therefore, shoulder the burden but in all three countries weak governing coalitions find it difficult to restrain spending at a time of fast economic growth.

Since the run on the Lat in February, the Latvian government at least has tightened credit rules and spending and postponed plans for cutting taxes next year (unlike Lithuania and Estonia) but no country is taking advantage of soaring revenues to build up significant budget surpluses.

So far the central banks have shied away from -making tough statements because of the risk of triggering an over-reaction.*Lithuania's government on Wednesday approved a fiscal discipline bill aimed at reducing the budget deficit and running a surplus as long as the Baltic state's growth remains strong, the finance ministry said. Rimantas Sadzius, finance minister, said in a statement that the bill, which needs to be approved by parliament, would "significantly" help Lithuania's effort to join the eurozone by pushing the country to meet the Maastricht criteria for common currency membership. The country runs a currency board with the litas pegged to the euro, so fiscal policy is the only instrument the government can use to fight high inflation. Lithuania's inflation rate was too high for eurozone entry this year. The bill says the budget deficit should not exceed 0.5 per cent of GDP in 2008.

Heat is on for Latvia bank chief

The Latvian economy is close to overheating but growth has peaked and care must be taken not to slow it down too rapidly, says Ilmars Rimsevics, central bank governor.

"We gave warnings that the economy needs some slowing down," Mr Rimsevics told the Financial Times. "But you can't just put on the brakes like a car.

"He said: "I am not ready to blow the whistle and say there is a problem."

Latvia's economic growth was 11.2 per cent in the first quarter of this year. Given the country's currency peg, Latvijas Banka does not have any instruments to restrain the economy, Mr Rimsevics pointed out, and fiscal policy also was of limited use. "Even an 8 per cent budget surplus would not solve the problem automatically.

"Mr Rimsevics argued that Latvia must just "live through" the current period and not take any counter-productive steps. "It is very important for us to land the economy softly. We are not after "big bang" measures, which, used simultaneously, could provoke a faster slowdown than necessary.

As we start the second half of 2007 it is a good time to step back and attempt to assess where things stand. There is little question that the overall market is still quite strong. You might question how extended it is technically, but the major indices all have some upside momentum and decent underlying support. The pace of the advance has slowed and been a bit choppier recently but there is nothing overt that indicates that we should be overly bearish.

If we look at sectors the most troubling group is financials and bonds. Both have bounced back in the past week after taking a hit but technically look like possible shorts. Take a look at the Financial Select SPDR (XLF) , iShares Lehman 20+ Year Treasury Bond (TLT) and the iShares Lehman Aggregate (AGG) , which all look like they could easily rollover again after recent bounces. It makes sense that these sectors would look vulnerable as the subprime issue is still out there and many, if not most, of the pros in the industry are looking for further problems.

Housing stocks obviously looks terrible but that isn't any big surprise. What is far more important is retailers. They have not been hurt much at all by the housing problems or higher energy prices and as long as they can hold up that bodes well for the market.

Oil and energy remain quite strong, which is probably indicative of a strong world-wide economy. Although high energy prices are essentially a tax on business and consumers they also are a function of strong international demand. It is wrong to automatically conclude that high oil is a market negative since the industrial growth that is driving it may more than offset the drag it has on consumers.

The most interesting sector in the market right now is semiconductors. The technical pattern there is probably the best of the major groups right now which is interesting because we are entering the time of the year when technology stocks are typically the weakest. A lot of folks are skeptical of the group but if it does continue to act well it is likely to be the group that leads the market higher.

My game plan at this point is to lean bullish but to attempt to take advantage of short-term volatility. I suspect earnings season may turn out to be fairly good given how well we did in the first quarter but expectations are likely to have moved higher and until we see the reaction to some reports we won't full know the market mood.

We have our work cut out for us if we hope to profit from this market. Flexibility and an open mind are going to be more important than ever as we navigate a variety of cross-currents.

We have a slightly positive start shaping up. The acquisition of Hilton Hotels (HLT) by Blackstone (BX) is the big news this morning and is helping the mood a bit. Overseas markets are mixed with a rather sharp dip in China and little reaction in Europe as the Bank of England hiked interest rates a quarter points as expected. ---------------------------Ülespoole avanevad:

One thing that is particularly interesting about this market right now is that oil is strong, interest rates are rising, housing is terrible and the economy is mixed, yet retail stocks are still holding strong and the consumer does not seem to be buckling.

At some point, it would appear that we are going to have a showdown, but for now, despite the obvious pressures on the consumer, the market simply isn't too worried.